Speech by SEC Commissioner:
Remarks before the ICI Equity Markets Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
New York, NY
September 22, 2005
Good morning. I am delighted to have been invited to the ICI's Equity Markets Conference. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
This is one of my first opportunities to address an industry group since being appointed a Commissioner of the SEC. When asked recently how being a Commissioner differs from being the Director of Market Regulation, my response was that being a Commissioner means never having to give a speech on the Order Protection Rule again! But alas, I find myself here at an equity markets conference and the temptation is simply too great. I will strive, however, to move after a brief time beyond the familiar to address the more ethereal issues that are the province of Commissioners.
As you know, last April the Commission took an important and necessary step in modernizing the regulatory framework governing our equity markets by adopting Regulation NMS. Today, the National Market System includes more than 5000 listed companies and over $17 trillion in U.S. market capitalization and NMS stocks trade concurrently in a variety of venues, including national securities exchanges, ATSs, and dealer markets. The variety of market centers and market models, and the competition among them, is a significant reason for the vitality and efficiency of the U.S. equity markets. Regulation NMS reinforced the Commission's commitment to a marketplace comprised of multiple, competing markets while addressing the overarching principles of best price, fair access, minimum quoting increments, and price transparency. Specifically, the new Order Protection Rule reinforces the fundamental principle of obtaining the best price for investors among automated quotes that are immediately accessible; the new Access Rule promotes fair access to NMS quotes in various markets through private linkages; the new Sub-Penny Rule, by establishing a uniform minimum quoting increment, promotes consistency across markets; and the amendments to the Market Data Rules and joint industry plans reward SROs for their contributions to public price discovery and promote wide distribution of market data.
There was unquestionably a lively debate on a number of aspects of the regulation, but consensus emerged on the need for change and the desirability to take some action without further delay. With Regulation NMS, the Commission strengthened the foundation of the equity markets to ensure that these markets will well-serve the interests of investors, listed companies, and the public for years to come. The regulatory certainty that Regulation NMS provides has enabled the markets to make plans, to move forward, and to innovate in ways that serve their own economic interests as well as those of the investing public.
Since the adoption of Regulation NMS, we have witnessed proposals to change the NYSE's auction market that were previously unimaginable, as well as several proposed market mergers. While I would not suggest that Regulation NMS directly caused these developments, I do believe that the Commission's regulatory action provided the needed certainty and a framework in which such changes could occur. It has unleashed competition between the Nasdaq and the listed markets heretofore unseen, and it has done so under a uniform rule set that ensures that all competitors, both large and small, can coexist in one vibrant marketplace. The NYSE's Hybrid Market Proposal is a recognition that the NYSE must undertake significant changes to its auction market structure by increasing the availability of its automatic execution system in order to compete more fully with electronic markets, while at the same time retaining certain traditional aspects of its floor-based model. This proposal is a true hybrid of electronic and floor-based models which reflects the impact of competition, technological changes, and regulatory developments. I believe it should significantly change market dynamics.
Within weeks of the adoption of Regulation NMS, the NYSE announced its intention to merge with Archipelago and Nasdaq announced its intention to merge with Instinet. The driving force behind these mergers appears to be the prospect of building stronger, more diverse, and more competitive marketplaces. In each case, the parties expect to combine the best features of each other's market to improve liquidity and executions and, of course, profits. NYSE and Archipelago seek to position the new entity as the preeminent global marketplace for equities, options, and other derivatives, providing additional growth opportunities and more choice for investors. Similarly, with its acquisition of Instinet and, previously, Brut, Nasdaq seeks to significantly deepen Nasdaq's liquidity pool and avail itself of Inet's lower-cost, more efficient platform for the Nasdaq Market Center. Nasdaq's goal is to increase efficiency, liquidity, and the opportunity for an execution on a Nasdaq trading system. It hopes to attract new listings and expand choices for investors accessing the Nasdaq market.
The marketplace's competitive response was not limited to the NYSE and Nasdaq. We have also seen proposals by various regional exchanges that are designed to provide an alternative trading venue to the two dominant markets. There has even been discussion of the creation of one or more new ECNs.
The brokerage industry's response since the adoption of Regulation NMS has been very constructive. Efforts are underway both at the firm and market levels, as well as through trade groups, to meet the various compliance deadlines. I encourage you to take stock within your organizations of any issues you may have in developing systems and procedures to comply with Regulation NMS and, for those areas where guidance would be helpful, to communicate with the Commission staff as soon as possible. I expect the staff, with Commission oversight, to issue guidance to assist the industry in implementation. Experience with past NMS rules has demonstrated the very important role of industry feedback in achieving an implementation process that is as smooth and cost-effective as possible. I cannot emphasize enough how important it is to hear from you about implementation concerns.
In addition to Regulation NMS implementation, there is much need for vigilance in the options markets. There has been notable progress in the options markets in the last several years, with the entry of new fully electronic options markets, the linkage of the options markets, and the introduction of full-scale multiple listing of options products. These events have fostered greater contract volume and a significant narrowing of spreads, ultimately leading to better executions for customers.
But more needs to be done.
Pricing inefficiencies caused by nickel and dime increments lead to payment for order flow practices. Yet even without penny quotes, exponentially increasing quote traffic places burdens on all market participants' systems. Progress in this area has been slow in coming. There are a number of approaches the Commission could take to tackle these issues. My preference would be to start by implementing execution quality statistics for the options markets similar to those we have for the equity markets. A lack of transparency concerning execution quality impairs the ability (and motivation) of broker-dealers to trade between the quote.
Having discussed these current market issues that we face, I thought I would turn to the broader regulatory challenges that we all confront as the financial landscape gets more sophisticated and multi-dimensional. I will attempt to use some recent examples to illustrate the dilemmas we face.
Issues arise with greater frequency when economically equivalent products trade in different venues under different rule sets, or when the introduction of certain products is delayed due to regulatory uncertainty. One example of such a challenge that was the subject of Congressional focus and action was single stock futures and narrow based index futures.
When the Shad-Johnson jurisdictional accord was reached decades ago, the decision was made to prohibit the trading of single stock futures and narrow based indexes. Both the CFTC and the SEC recognized that futures on single stocks can trade as substitutes for the underlying securities, and thus futures transactions can impact the underlying securities markets. The same is true for narrow based indexes, which like the single stock futures could be used as vehicles for insider trading and market manipulation, problems quite familiar to participants in the securities markets and for which there are advanced compliance and surveillance systems in place. But banning these products was not the only solution, and was far from the optimal one. Thus, through the Commodity Futures Modernization Act, Congress crafted a framework of shared regulatory authority to ensure that the goals of both regulatory regimes would be achieved and to avoid regulatory arbitrage between the futures markets and the securities markets for these products. The CFMA provided that the margin on single stock futures must be comparable to the margin on options. As you know, the margin on options is currently much higher than that of futures. Some believe that the higher, options-style margin levels have thwarted the successful introduction of single stock futures. While I suspect that the reasons are more numerous and subtle, I strongly support the move to portfolio margining in the options market as promptly as possible. These risk measurement techniques are recognized by regulators in many mature market centers and it is time for the securities SROs and the Commission to do likewise.
Portfolio margining will recognize most types of offsetting positions and permit calculating margin based on the sensitivity to price movements of an entire portfolio of securities held in a margin account. This approach to margining accounts for risk and price sensitivity, not on a security by security basis, but rather measures net exposure across related products in a portfolio. Once portfolio margining is implemented, futures based on single stocks and narrow-based stock indexes will be able to trade at margin levels that, while still prudent, more closely reflect the risk of the portfolio. The Commission recently approved the pilot programs of two of our SROs relating to portfolio margining. My hope is that we will expand this effort to a broader range of products post haste.
During the adoption of the CFMA we were afforded the opportunity to debate and consider the policy issues of products that fell within a jurisdictional "fault line" in the context of a legislative solution. A serious dialogue ensued over the purpose of regulation in this area, the consequences of altering the jurisdictional lines, and the cost implications of achieving the regulatory goals. This type of in-depth and thoughtful analysis, followed by clear Congressional action, is not always possible, yet these types of issues continue to manifest themselves in enumerable ways.
Regulators and market participants struggle with laws and regulations that never anticipated certain types of products or business structures. For instance, take what is considered today a somewhat commonplace occurrence-shareholder owned exchanges. It is clear from the Exchange Act that Congress never contemplated such a structure back in 1934. The Exchange Act was written at a time when mutual ownership of exchanges was the norm. Members, or users, of the exchange were the exclusive owners of the marketplace. Thus, the questions that we grapple with in our proposed Regulation SRO, such as limits on ownership of exchanges, either by broker-dealers or others, and whether and how to separate the regulatory function from the market operations, are unanswered by the statutory language. Yet market participants need certainty and the rules of the road must be clear for them to function efficiently and compete effectively in a globally competitive marketplace.
We are also seeing much more activity that I would describe as taking place at the "seams"-whether the seams are where the jurisdictions of various regulatory agencies meet, or where the rules of any particular regulator apply, or even what body of law applies. One recent example that I believe raised serious issues for the marketplace relates to the intersection of intellectual property rights and securities law. In a decision from the Southern District of New York, Judge Baer dismissed McGraw-Hill's and Standard & Poor's claims involving exclusive property rights in the issuance and trading of options on index-tracking securities such as DIAMONDS and SPDR products.
The case arose when the ISE announced its intention to trade, and the OCC its intention to clear, options on SPDRs in January 2005. Previously, options on SPDRs did not trade widely because S&P refused to grant licenses and the CBOE had an exclusive license to trade options on the S&P 500 index. Later in May, ISE and OCC announced their intention to trade and clear options on DIAMONDS, again with CBOE having an exclusive license. The two cases were consolidated. McGraw-Hill and Standard and Poor's complaints alleged misappropriation, trademark infringement, unfair competition, and trademark dilution of the intellectual property in the ETF product, whether SPDRs or DIAMONDs.
In the court's decision, Judge Baer rejected plaintiffs' assertions that the creator of an ETF based on an index retained a proprietary or other protectable interest when options on the ETF are offered in the secondary market. In short, the property rights associated with an index itself do not extend to every product that happens to use the index only as a reference point. Judge Baer reasoned that an ETF is further attenuated in that the value did not rely solely on the index for its existence or value. Judge Baer referenced the analogy previously used in the Golden Nugget case that sales of shares are like sales of second-hand cars, in that no protectible interest exists where the purchase and sale of ETFs (and options on ETFs) are not controlled by the issuer. Further, Judge Baer clarified that describing these ETF products non-deceptively, that is, merely referring to the index creator in the product name, does not infringe on the trademark.
I believe this decision is terribly important because the result is consistent with the strong public policy of promoting multiple listing and trading of products in our national market system. Just one day after Judge Baer issued his opinion, DIAMOND options began trading on multiple exchanges. As a result, the CBOE aggressively reduced the transaction fees it charges customers to trade DIAMOND option contracts (from 45 cents to 15 cents for options over $1). The CBOE also eliminated the license fee surcharge applicable to market maker transactions in options on DIAMONDs. What better evidence of the salutary benefits of competition on the markets could there be?
Our regulatory challenges, and some of the most important areas requiring oversight, not only cross jurisdictional lines between U.S. regulatory regimes but also cross boundaries between regulated and non-regulated entities and across geographical regulatory boundaries as well. For example, in regulating complex financial institutions with many affiliates and world-wide operations, the Commission historically has had limited means to examine and consider the financial activities and internal controls of the entity as a whole, all of which may impact the financial health of a U.S. broker-dealer subsidiary or may raise systemic risk concerns to the financial system as a whole.
One recent success story in which a flexible approach was crafted to address these concerns was in our development of the consolidated supervision program. A number of our largest, most complex broker-dealer holding companies have elected this voluntary regime. To do so, they must consent to examination of the holding company and unregulated affiliates, in addition to the registered broker-dealer. They must also provide additional financial and risk information at the group level on a regular basis. But in recognition of this enhanced oversight, such firms are permitted to compute regulatory capital using the statistical models, such as VAR and scenario analysis, developed for internal risk management purposes. Not only does this regime allow the firms to leverage their appreciable investment in internal risk management infrastructure for regulatory purposes and better align economic with regulatory capital computations, but the approach is also similar to that applied by the banking regulators to their most complex holding companies. This convergence of approaches has been well received by the regulated entities and bodes well for greater convergence of approaches in the future.
We continue to hear concerns among market participants concerning the cost of disparate regulation, whether domestically or internationally. Disparate rules are costly to implement, and particularly when transactions are increasingly cross-border, the difficulties of complying with different regulatory approaches can be daunting. Further, significant differences in regulatory regimes can motivate market participants to take advantage of these differences. Financial engineers of novel products and services naturally try to maximize the competitive advantage to be gained from regulatory differences. But choices based on regulatory arbitrage alone can distort the markets. Regulators are aware of these issues, but the solutions are often difficult to achieve. One area where I believe we have made real progress was in the area of soft dollars. As you know, the Commission voted to issue a proposed soft dollar interpretation yesterday that we will be publishing for comment. Commission staff gave careful consideration to industry practices, technological developments, and their experience based on examinations of advisers and brokers in formulating guidance on brokerage and research within the safe harbor. A constructive dialogue between Commission and FSA staff on these issues helped us craft a consistent regulatory approach to the extent possible. I believe that each agency benefited from the work of the other. This type of regulatory cooperation is a model for further efforts in the future.
As I have highlighted today, regulation is increasingly challenging in a complex, ever evolving financial environment. New products and business combinations test the limits of our current rules, and business activities occur without regard to traditional notions of geographical boundaries or a regulator's jurisdictional limits. With these challenges come opportunities, however-the opportunity to create new flexible frameworks for the marketplace of the future, the opportunity to test the efficacy of certain traditional regulatory concepts, and ultimately, the opportunity to create a better, more efficient environment based on consistent principles in which business can flourish. Ultimately, we should strive to achieve a flexible regulatory framework that fosters innovation and competition, that furthers market integrity and investor protection, and that achieves these goals in a cost-effective and efficient manner. The years to come will provide us with countless opportunities to work toward these goals.